U.S. High-Yield Cheap Versus U.S. Equities

Source: Wall Street Journal


The credit spread on Merrill's U.S. high-yield index was 1674bp on January 16, 2009. There has been significant contraction from the all the high of 2178bp in late 2008. The question is whether the asset class is a buy at current valuations. To answer that question we need to figure out the likely default and recovery rates going forward.

There is a negative correlation between recovery and default rates.

Recovery Rate = 0.52 - 6.9 * Default Rate (Moody's)

This equation suggests that recovery is going to be very low given the 10% plus default rates that we are likely to witness.

Speculative Grade Default Rates
YEAR**Default Rate
1929**1.29
1930**2.13
1931**2.13
1932**7.85
1933**10.81
1934**15.39
1935**5.93
1936**6.09

Source: Moody's

This data indicates that there is a lot of value in the HY asset class even if an economic scenario akin to the Great Depression were to materialize.

One caveat is that the speculative grade market in those days comprised fallen angels. It is important to understand how this segment differs from original issue high-yield bonds. As per Moody's research: "In comparison to other speculative-grade issuers with the same ratings, fallen angels are more risky (more likely to default and less likely to rise to investment grade) for the first two years after being downgraded to speculative grade, but they become relatively less risky than other speculative-grade issuers as time progresses."

Another issue could be whether the current high-yield universe is worse than the previous vintages.

All said, it seems that current spreads discount a pretty bad economic scenario and provide considerable margin of safety. That is certainly not true for U.S. equities.


Source: Default and Recovery Rates of Corporate Bond Issuers, 1920-2004; Moody's Investors Service
http://www.moodys.com.br/brasil/pdf/default2005.pdf
Source:What Happens To Fallen Angels? A Statistical Review 1982—2003;Moody's Investors Service
http://v2.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20pages/Credit%20Policy%20Research/documents/current/2002000000425343.pdf